Shadow of the Colossus: Euro Area Spillovers and Monetary Policy in Central and Eastern Europe

Abstract

Closer integration between Central and Eastern Europe (CEE) and the EU has opened up channels facilitating the propagation of economic shocks from the core to the eastern periphery. This paper examines the effects of such shocks to economic activity and monetary conditions originating in the Euro Area (EA) on output, prices, money, and interest rates in 10 CEE countries over the period 2005-2018 using a bilateral restricted VAR framework. In contrast to previous studies, we use Divisia monetary aggregates and compare the effects of EA spillovers to domestic shocks. The results indicate that EA shocks explain the majority of variation across all macroeconomic indicators, with money supply shocks playing the most prominent role. Despite some heterogeneity, the impulse response of monetary aggregates to domestic and EA monetary shocks is almost identical across countries. The impact of the EA shock increases over time and persists, while the domestic shock dies out relatively quickly. Accordingly, we find no meaningful monetary independence in the majority of CEE countries. This is likely to prove detrimental to the effectiveness of monetary policies in CEE.